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Intermediate Macroeconomics Chapter 4 Introduction to the Equilibrium Model Introduction to the Equilibrium Model 1. 2. 3. 4. The Parsimonious Model What is an Equilibrium Model? Equilibrium Model Solution Method Simple Equilibrium Model in Action Intermediate Macroeconomics 1. The Parsimonious Model Make simplifying assumptions Parsimonious – stingy, miserly Occam’s Razor - eliminate complicating details that don’t significantly contribute to the model • Don’t include unimportant variables • Ceteris Paribus (other things being equal) - Hold constant variables that are not the focus of your interest Intermediate Macroeconomics 1. The Parsimonious Model Simplifying assumptions for our models Aggregate output ≡ National income National income ≡ Personal income Intermediate Macroeconomics 2. What is an Equilibrium Model? Assumed equilibrium condition • GDP Accounting (Chapter 2): National Income ≈ Aggregate Supply • Macroeconomic Models: Aggregate Supply (AS) = Aggregate Demand (AD) or National Income (Y) = Aggregate Demand (AD) Intermediate Macroeconomics 2. What is an Equilibrium Model? Disequilibrium • Disequilibrium: aggregate output (or national income) is not equal to aggregate demand • Undesired Inventory Accumulation: a symptom of disequilibrium where aggregate output > aggregate demand • Undesired Inventory Draw: a symptom of disequilibrium where aggregate output < aggregate demand Intermediate Macroeconomics 3. Equilibrium Model Solution Method 1. Substitute the given equations into the equation for aggregate demand AD. 2. Apply the assumed equilibrium condition: Y = AD 3. Substitute the derived equation for AD from step 1 into the right-hand side of the equilibrium condition in step 2. 4. Simplify the equation. This often means solving for income (Y), since Y should appear on both the left- and right-hand sides of the equation in step 3. Intermediate Macroeconomics 4. Simple Equilibrium Model in Action Describing the economy AD = C + I + G + NX AD = aggregate demand C = consumption I = investment D = government spending NX = net exports (exports – imports) YD = C + S YD = disposable income S = savings YD = Y + TR – TA Y = national income TR = government transfer payments TA = government taxes Intermediate Macroeconomics 4. Simple Equilibrium Model in Action Solving the model 1. Substitute given equations into equation for AD: YD = YD C + S = Y + TR – TA C = Y + TR – TA - S AD = C + I + G + NX = (Y + TR - TA - S) + I + G + NX 2. Apply equilibrium condition: Y = AD 3. Substitute solution for AD from Step 1: Y = Y + TR - TA - S + I + G + NX 4. Simplify equation: G + TR - TA = S - I - NX Intermediate Macroeconomics 4. Simple Equilibrium Model in Action Implications of the model In equilibrium: G + TR - TA = S - I - NX • Crowding Out • Ricardian Equivalence • Twin Deficits Intermediate Macroeconomics 4. Simple Equilibrium Model in Action Crowding Out In equilibrium: G + TR - TA = S - I - NX Assume: – Increase in government deficit (G + TR - TA) – Savings (S) and net exports (NX) constant Result: – Decrease in investment (I) Intermediate Macroeconomics 4. Simple Equilibrium Model in Action Ricardian Equivalence In equilibrium: G + TR - TA = S - I - NX Assume: – Increase in government deficit (G + TR - TA) – Investment (I) and net exports (NX) constant Result: – Increase in savings (S) Intermediate Macroeconomics 4. Simple Equilibrium Model in Action Twin Deficits In equilibrium: G + TR - TA = S - I - NX Assume: – Increase in government deficit (G + TR - TA) – Savings (S) and investment (I) constant Result: – Decrease in net exports (NX) Intermediate Macroeconomics 4. Simple Equilibrium Model in Action Implications of the model G + TR - TA = S - I - NX Implications of an increase in the Government Budget Deficit, G + TR - TA: Savings Investment Net Exports Ricardian Equivalence Increase Assume Constant Assume Constant Crowding Out Assume Constant Decrease Assume Constant Twin Deficits Assume Constant Assume Constant Decrease Intermediate Macroeconomics